Putting a dollar value on IT outsourcing contract terms

Today's savvy IT leaders go into outsourcing decisions thinking about the business value of a potential deal--from scope to service levels to price. But they're overlooking the value of the contract terms that can make or break an outsourcing engagement, says Brad Peterson, partner in the outsourcing practice of law firm Mayer Brown. By estimating the dollar value of the most important commitments, options and incentives clauses in the agreement, customers could make much smarter decisions about how to set up the relationship, but few do.

"For the most part, customers haven't thought of valuing contract terms or wouldn't know how to go about it," says Peterson. "Some believe that terms are a 'soft' benefit and, thus, impossible to value accurately. Also, procurements teams are often compensated based on 'savings' without regard to whether the contract will allow them to realize that savings." But you can bet your IT service provider has a dollar amount assigned to every term that might make it to the negotiating table.

If customers don't price out contract terms, they may end up pushing hard on terms with little value while overlooking those that could cause deal degradation down the line. Many IT leaders today, for example, are driving hard bargains on limits of liability for data breaches that are unlikely to occur, says Peterson. Meanwhile, they happily sign off on "sole remedy" language that limits the customer's recourse when a vendor fails to meet its responsibilities. "Customers might be impressed by the strong promises at the start of a contract and miss the fact that the 'sole remedy' clause means that those promises don't provide value," Peterson says.

Estimating contract terms isn't easy. Even experienced third-party advisors don't do it; consultants have limited understanding of the legal language and lawyers lack the business background to run the numbers. But valuing contract terms at zero can lead to surprise charges, lack of control, inability to exit, or compliance failures. One of Peterson's clients, for example, had previously opted for a yearly software license as part of an outsourcing arrangement in order to skirt the perpetual license fees. A few years in, the software had become a fundamental part of the client's business and the annual fee jumped 20 percent. "They asked us what they could do and, because their price lock lasted only three years, the contract was no help," Peterson says.

It might be a mistake to invest the level of resources required to nail down an exact value for every term, customers can focus on negotiations where there are clear choices to make--like the choice between two providers or between a price cut and better terms. "Start with a high-level look at key terms and then build a more detailed view," says Peterson. "You need to balance the value of better results with the cost of analysis." In many cases, IT leaders have already gathered or created data as part of making the business case for outsourcing that can help evaluate contract terms. For example, if the value of the desired business outcome is estimated, that estimate can be used to put a dollar figure on any terms that effects the probability of achieving that outcome.

It's also important to look at the contract terms in aggregate. "An individual contract term may only be effective if related contract terms are also effective," Peterson says. A strong commitment clause will be of little value if there is not also a contract term that provides a remedy for breach. Here are some types of contract terms and methods for putting a price tag on them.

Customers can estimate the additional cost of the most likely outcome without the commitment -- the additional amount a supplier might charge without the commitment or the cost of alternative sourcing. For example, says Peterson, if the contract in essence exchanges a long-term commitment for a 10 percent reduction in cost compared to spot market prices, that 10 percent could be an estimate of the value of failing to secure the commitment.

For a straightforward option -- like termination for convenience -- simply calculate the probability of exercising the options and multiply by the economic benefit of doing so. If the supplier agrees that a termination-for-convenience charge will be reduced by $2 million if related to a change of control and the customer estimates a 5 percent probability of making that choice, the value of that provision is $100,000. Options that provide softer benefits -- like agility -- are difficult to estimate with precision. But "an estimate based on the collected best judgment of your team will be superior to ignoring their value," Peterson says.

Incentives

These terms encourage the supplier to act in the customer's best interest. Examples include service-level credits, deliverable credits, holdbacks, gain sharing, obligations for the supplier to correct its errors at its cost, and indemnities against harm caused by the supplier. Subtract the economic value you expect to derive without the incentive from the economic value you expect to derive if you have the incentive to determine its value. But, notes Peterson, the strength of an incentive depends on its value relative to the supplier's cost of achieving the desired result. For every dollar that the customer wants the supplier to invest in reducing a risk by 1 percent, the supplier should have at least $100 at risk. Anything smaller puts the term in the "cost of doing business" category rather than an incentive, Peterson says.

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